We develop a nonlinear model in which trend inflation and inflation tail risks emerge endogenously in equilibrium from the interaction between the primary deficit and the risk of supply disruptions. The key friction is limited fiscal responsibility - the government stabilizes debt in the long run but, unwilling to let debt accumulate too quickly, pressures the central bank to restrain interest-rate increases rather than adjust its own budget. The fiscal limit binds asymmetrically across shocks, with inflationary supply shocks especially likely to push monetary policy against the constraint. As supply-shock volatility rises and fiscal space narrows, the constraint binds more often. Anticipating this, agents raise their inflation expectations, causing trend inflation and upside inflation tail risks to rise even before the constraint binds. Movements in supply-shock volatility and fiscal space together account for much of the ratcheting up and down of U.S. trend inflation between 1965 and 1990. Interpreted through the model, the post-pandemic rise in long-run inflation expectations reflects a higher probability of fiscally constrained monetary policy.
Professional forecasters’ long-run inflation expectations overreact to news and exhibit persistent, predictable forecast errors. We uncover the cognitive biases allowing an imperfect information model to explain these features of the data. Our analysis highlights substantial, time-varying heterogeneity in forecasters’ responses to public information, with sensitivity declining across all forecasters when monetary policy is constrained by the effective lower bound. The model serves as a framework for evaluating, in real time, whether the inflation paths communicated by policymakers are consistent with long-run expectations remaining anchored at the central bank’s target.
We study the distributional consequences of persistent inflation. Using a trend-cycle decomposition and principal component analysis, we identify trend inflation innovations linked to monetary and corporate tax shocks. Trend inflation redistributes resources through debt revaluation, asset price movements, and income composition. Similar trend shocks generate different distributional outcomes depending on their source. Monetary-driven inflation raises house prices and benefits outright owners and mortgagors. Corporate-tax-driven inflation depresses house prices and primarily protects mortgagors through debt revaluation. Housing tenure is the main dimension of heterogeneity; renters consistently experience weaker consumption outcomes because they lack offsetting gains from asset appreciation or debt erosion.
We provide evidence on how banks and non-bank financial intermediaries differ in their response to monetary policy. Our findings are based on a standard empirical macro model for the euro area, augmented with balance sheet data for banks and investment funds. The model is estimated via local projections, using high-frequency methods to identify different types of monetary policy shocks. Short-rate shocks lead to a significant balance sheet response of banks and investment funds, with a slightly swifter and more persistent reaction of banks. Long-rate shocks instead exert only short-lived effects on bank balance sheets, whereas investment fund balance sheets exhibit a stronger and more persistent response. The relative role of different types of financial intermediaries hence emerges as a relevant factor in shaping the transmission process for conventional and non-standard monetary policy measures.
This paper studies the effect of different types of monetary policy announcements on household inflation expectations based on micro data from a survey of German households. As a key feature, interviews of the survey were conducted both shortly before and after monetary policy events. This timing provides a natural experiment to identify the immediate effects of policy announcements on household inflation expectations. The availability of the survey over a period of 15 years further allows me to exploit the time-series dimension to estimate the medium-term effects of policy announcements. Policy rate announcements lead to quick and significant adjustments in household inflation expectations. Announcements about forward guidance and quantitative easing, by contrast, have no or only smaller and delayed effects.